I recently came across the website RealInvestmentAdvice.com and their discussion on the yield curve flattening. I also read the Investmenthouse.com and their discussion on the FED always overshooting interest rate hikes. This weekend’s newsletter from Investmenthouse.com even referred to the FED member’s justifications towards the flattening that the yield curve is no longer accurate; this time it’s different; etc. It appears we will be a victim of the fed again.

There are two factors at work with rate hikes, one is size (25 basis points, versus 50 basis point rise) and time. My question, if we know there is data showing a softening and there could be a need to postpone (versus withdrawl) and planned rate hike, what’s the harm? I believe the fear is the market will react to that and they fear a selloff. That is not the FED’s mandate however. Just like previous presidents, secretaries of state, and congress, there has been very little decisive action, unless there is maximum pain in not making that decision. Hopefully, the FED takes a play out of President Trump’s playbook and decides to be proactive versus reactive.

For reference, as of this writing, the 2/10 yield curve is sitting at .21 and heading for inversion.

In this video we explain how to convert a scan into a watchlist on the think or swim platform from TD Ameritrade. This can be useful if you want to limit your underlying stock or ETF decisions based on a smaller group of stocks that have certain guidelines in common, for example, average trading volume.

The video shows an average trading volume scan and how I converted it into a watchlist. Additionally, I show how to customize the columns on the watchlist. I have found this is an easier process to find stocks of interest than to use the scan tab for my basic trading guidelines. This is the perfect way to find high IV rank stocks quickly.

This video was previously posted on Selltheta.com, however, we’ve consolidated our posts to reside on ChristianMeadows.com. Instead of forums, please feel free to post a comment below and we’ll try answer your questions.

Before we get started, please understand this article is to orient you to the opportunities. This is in no way a “How to” guide, as there are more dynamics at work. The goal is to hope you will learn more about options.

Options allow you to limit your risk

Options are a unique vehicle for investing in that you can pair two different options and limit your risk directionally. This is called spread trading. For example, if you are bullish on the stock market, you may sell a put lower than the market and then by one of few strike prices beneath the option you sold. What this is allows is for you to profit by selling an option but also protecting the risk if the trade goes against you. Here is an example, if the $SPY is at $265.00:

Sell 1 put at the $245 strike, approximately 45 days out for $1.78 Buy 1 put at the $240 strike, at the same expiration for $1.30

The potential profit is $48 dollars, and your risk in the trade is $452.00. That is a 10% return for 45 days. Now, this is somewhat oversimplified, but bear with me. The market is currently at $265 and your short strike is $20 below the market. That equates to 200 points on the S&P 500 index. That means the market has to go down that much, and stay down, at the time of expiration. What are the odds of that happening? About 16%. You have an 84% of the market staying above that amount.

There are many places to learn more about how to trade vertical spreads. You will have to invest some time and effort, but as you can see in the example above there is profit to be made. If you make 10% every 45 days (not that I recommend holding these options to expiration), you wonder why people invest a lot more, have a lot more risk, only to make about 8% per year which is the average S&P gain over time.

Options allow you trade without direction

Option traders can also trade without bias as to the direction of the market. One of the simplest trades involves two short vertical spreads as I explained under header number one. To make this a nondirectional trade, one would simply add a short call spread at the same time they traded the short-put spread. This is called an iron Condor. Here’s the trade you would add to the trade we talked about above to complete your iron Condor trade:

Sell 1 call at the $275 strike, at the same expiration for $1.69 Buy 1 call at the $280 strike, at the same expiration for $0.77

Your profit on this trade is $92.00. Add this amount to your $48 in the example above and your potential profit is $140.00. Now the interesting part is the risk on your short put vertical and the short call vertical is the same risk. Why? Because the market can be up at expiration, or down at expiration, but it can’t be both. Therefore, your risk in the trade is now $360.00. This is where the magic happens. Now your profit is $140, your risk is $360 and your return is 39% (rounded).

If your underlying stock stays between $245 and $275, you make money. Without getting into the nitty-gritty, you can see the potential for profit is great, with no bias towards direction. This is not to say you will profit, because there are other factors at play with options. Volatility, interest rates, time to expiration, etc. For the other benefit of this type of trade, let’s move to #3.

Options Allow you to profit in your sleep

Options which are sold gives the seller the benefit of positive theta. Theta is one of the option Greeks which everybody should know about. Positive theta of say, one dollar, would yield you approximately one dollar a day, or $30 per month. If you own a stock that you’re holding anyway, why not write a call against it and make that money each month? There’s quite a bit to options trading and a lot of people will tell you that is more risky than stock. Let me pose a question. If you were long stock that you purchase for $10, you would have $1000 a risk if you owned 100 shares. If you were to make $30 per month for 12 months, you would profit $360 on your covered calls. All things being equal your risk would only be $640 at the end of your first year. After two and half years roughly you own the stock for free. If you made $30 a month for the rest of your life, you can easily see that positive theta has many benefits even if you are a buy and hold stock purchaser.

Options can insure your portfolio (and other things!)

Many people use long puts to ensure portfolio against downside movement. This is a good strategy if you’re worried about a short-term event, say a few days. The problem is if you’re worried about an event so is the rest of the world. Concern about the event could increase the volatility and thus the price of the option. Once the event ends, the volatilities deflated in the option becomes very cheap. This makes insurance using options a little more expensive. Buying long puts creates negative theta, which means you’re losing money each day. This is not the best strategy, you options traders and stock owners should be aware of the possibility of insuring your portfolio.

Options can simulate stock purchases (for much less!)

Most people do not know the you can simulate a long stock purchase for much less than the cost of ownership of that stock. This is done by buying a long call and selling a short put. If you were to purchase of Twitter by now at approximately $31, a $30 strike long call and short put it would cost about $220 and hundred shares in equivalent stock. Because you have a short put your risk is a little higher in that the margin would be around $1000. Your risk in the underlying stock would be $3000. Therefore, you have about a 60% reduction in risk. There is more to this and that this is also a negative theta training, however, if you expect a short move to the other side in a stock, this may be a way to make that play with last investment.

The intention of this article is not to make options traders out of everybody, but to make everybody aware of some of the benefits of options. There is much more to options and can be covered in a single blog post. There are many ways to learn options, one of the best however, is to watch TastyTrade. I would love to make the videos myself, the wife created the wheel and somebody’s doing such a good job of it now.

Please understand that options involve risk, just as stock purchases. Please read the OIC’s document characteristics and risks of standardized options for more information.

But First, an Explanation

Before I get started speaking about Delta I want to correlate what I’m about to talk about to another aspect of life. Most of us learned to drive when were about 15 or 16 years old. We get the basics, we get formal education, and we learn mainly from our parents how to be good, defensive drivers. Most parents do not teach and do not know how to teach their children to be racecar drivers. However, we can all agree that racecar drivers are probably a cut above the average driver from the standpoint of understanding the dynamics and physics of speed. If a parent is a racecar driver, the child that he’s teaching most likely will have a better understanding of the dynamics that the parent knows. The discussion in this article is really designed to learn the best tactics that a racecar driver will know and apply it to every day driving. Replace that with stocks and options and you’ll understand my goal in explaining this to the average value investor.

What is Delta? A little-known concept know by retirees, those wanting to retire, and value investors is the concept of Delta. Delta is an option Greek that measures the options movement in relation to the price of the stock. Therefore, if an option has a delta of .5, it would move up $0.50 for every one dollar in the stock’s price move.

What is Delta? Why should I be concerned?

Every stock has a Delta of 1.0 for every share you own. So, if you own 100 shares of Apple you have a Delta of 100 and Apple stock. Generally, people investing in their retirement accounts are usually only long stock. When you are invested in long stock alone your portfolio Delta is always long the number of shares you own.

Unfortunately, most people do not know what Delta is nor do they know why they need to understand Delta. In retirement accounts, it is often hard to hedge against a down market with long stock. Many will balance with value plays like consumer staples, energy, or some other hedge against a down market. With a better understanding of Delta you can have a better understanding of what you need to do to protect against a down market.

What is my delta?

As I explained before, every stock has a Delta value of 1.0. You may ask, how you reconcile a Google stock ($GOOG) valued at $1100 in relation to a silver index fund ($SLV) valued at $15. This is where the concept of beta weighting comes in.

Beta Weighting

Beta weighting is simply the value of a stock in relation to another stock or index. Using the example above, Google has a beta weighting of 1.36, which means Google will move $1.36 for every one dollar move in the $SPX. $SLV on the other hand has a beta weighting of .176, which means again the stock will only move about $0.17 for every one dollar move in the $SPX. The $SPX, or S&P 500 index is one of the more broad indexes. To gauge the overall market against the $SPX seems the most reasonable, especially for a retirement account.

Many people are limited to the account type in Brokerage of their employer. For example, in my retirement account I cannot use either the brokerages listed above. However, do not fear as you can often approximate Delta risk or more simply use some tech simple technical indicators to hedge off that risk. In my retirement account, I will start buying long stocks that are either reverse ETF’s, or long volatility. As of this writing, I prefer $TZA which is an inverse Russell 2000 stock; $SDS, which is an inverse S&P ETF; and $VXX, which is a long volatility product. Please stay away from ultra short products, 3X products, and products that are cash settled. If you don’t know what these are, perhaps stick to the indexes and products mentioned above. When a stock market goes down $TZA will probably out perform in the short term, followed by $VXX. $VXX will outperform at the market bottom. $SDS will most likely hedge against a long-term down move. Be aware all these products do lose money if they’re held too long on an up move. Market timing is almost impossible, so the best way to hedge is to actually hedge. By this, I mean you should buy a small amount of shares of these hedging products when you feel the market is topping. If the market continues to be go up, simply by a few more shares over the days, weeks, and months. Please be careful not to buy too much. I’m suggesting the use of these products as a hedge, not as a directional investment. If you must use these products as a directional investment to the short side, consider using an options strategy, if your Brokerage allows.

The screenshots below compare the same portfolio at the same time with no beta weighting (left) and with beta weighting against the $SPX (right). You can see the extreme difference in looking at the same portfolio through a different lens. When you beta weight your deltas and get close to zero from a portfolio standpoint, you are lowering your directional risk to one side or the other. If the market were to go down and you had positions in the hedge products I mentioned above, you would sell these products when the market bottoms, or what you think is the bottom. If you make 15% – 25% I would recommend edging out or selling your hedge entirely. Remember, bulls make money, bears make money and pigs get slaughtered. If you think the market has further to run down then maybe keep a portion on the table but take the rest off. The beauty of the strategy is you now have your hedged money in cash to invest in long positions that pay dividends or you can write calls against (covered calls).

If you have any questions, please feel free to comment below and I will answer them best I can. In the meantime please also consider using PocketSmith for your accounting. It is the best product I’ve ever seen and want to support them. By clicking on the banner below you support our blog and the information we provide.